A man generally has two reasons for doing a thing: one that sounds good, and a real one" according to the legendary J. Pierpoint Morgan. Similarly, investment banks have two reasons for increasingly penetrating the pensions market.

The one that sounds good is that the needs of defined benefit plan sponsors are changing. The real reason is that clients can no longer tolerate mediocrity from the incumbents.

For sure, mounting regulation, increasing longevity and enduring deficits are forcing plan sponsors to pursue different options, according to the latest study sponsored by T. Rowe Price and Citigroup.*

At one extreme, they are implementing buy-out solutions and risk immunisation strategies that facilitate an earlier exit from active money management. At the other, they are investing in structured products and hedge funds in order to plug the deficits via uncorrelated asset classes.

In response, investment banks have set up stalls - as principals and intermediaries - that compete head to head with fund managers and pension consultants alike. Goldman Sachs' recent launch of a low-cost hedge fund tracker product is yet another sign of how the outsiders are leapfrogging the established players.

"Investment banks are emerging as one of the new players in the rapidly expanding market to help trustees and corporate sponsors manage their pension risks," says Clive Wellsteed, partner at Lane, Clark & Peacock LLP. "Although still early days, investment banks are considering opportunities ranging from setting up new insurance vehicles to cater for pension scheme buy-outs to developing financial instruments to trade longevity and mortality risk in the capital markets."

Furthermore, with pension deficits posing a balance sheet risk under new accounting rules, investment banks are utilising their contacts in companies that are also large plan sponsors, so as to stimulate interest in two symbiotic areas.
The first covers one-stop services under the banner of "fiduciary consultancy", which directly treads on the toes of traditional pension consultants, whose hegemony is also challenged by the emergence of new manager of managers' platforms offering identical services.

"Too often, pension funds' resources have been thinly spread across a range of activities and asset classes, exposing them to the 'key person' risk. Fiduciary management, provided by leading asset management houses, enables pension funds to focus on what they are really good at," says Ted Sotir, co-head of GSAM Europe. "This change is evolutionary, not seismic. But it will change the competitive landscape."

The second area covers tools that focus on inflation, currency and interest rate risks. W H Smith was one of their earliest users. Investment banks are helping to immunise these risks via derivatives, while developing "mortality derivatives" that hedge out the longevity risk.

But there is one big hurdle. Plan sponsors are cautious in view of the "hunter-killer" stereotype commonly associated with investment banks. No wonder some plan sponsors continue to use consultants to "check up" on them. The majority also use fund managers as their first port of call, while encouraging collaboration with investment banks in such areas as structured solutions.

Such collaboration forces fund managers to focus on their core areas of expertise. But it has a downside: if they fail to deliver acceptable performance, their inadequacies will be glaring.

That brings us to the real reason why investment banks are making such ambitious forays. It relates to the sheer scale of losses notched up by clients during the worst bear market in living memory. It has created a whole generation of disillusioned investors, who now demand absolute returns, backed by a value-for-money fee structure that clearly separates skill-based alpha and market-driven beta. Clients want credible options, not pious hopes.

While beta returns remain the main source of wealth creation for pension funds, they can now be accessed through a low-cost security. While the search for alpha goes global, the allure of derivatives and leverage becomes irresistible. Either way, investment banks are clearly in the driving seat.

"They have huge balance sheets, sophisticated trading desks and a raft of risk tools. At their core, they are very competitive. As they do not have a strong fiduciary heritage, they are competing and collaborating at the same time. But for how long?" asks Stephen Potter, head of Northern Trust, EMEA, Asia and Canada.

Recently, his company published a discussion paper reporting the views of industry leaders*. Its message was stark: client conservatism cannot forever suppress the cheaper, better alternatives that investment banks are well placed to provide. One leader even ventured the view that fund managers and pension consultants are still building sand castles while the tide is coming in.

Indeed, history shows that the most disruptive industrial change often comes from newcomers. What Japanese cars did to the western auto manufacturers, what low-cost airlines did to main flag carriers, what mobile phones did to land lines, investment banks can potentially do to fund management, as long as they cultivate long-term relationships.